As we move forward in this new year, veteran Bay Area office broker Dan Mihalovich shares his take on the current leasing outlook for office space in the region. Mihalovich, a top pro at Cushman & Wakefield for many years, is now a principal at Mihalovich Partners, a tenant representation firm based in San Francisco. These comments are part of a quarterly column that Dan provides for interested parties that come to his site for market information, and for his clients, and therefore are written with more of a tenant perspective on market conditions.

Few of us will look back longingly to 2001. If the weak economy hadn’t already done its damage by 9/11, the ensuing atrocities crippled the San Francisco Bay Area business community. By year end, Wall Street reported the weakest corporate earnings since World War ll. The pace of job layoffs, which has been devastating in this area, has slowed to the point of encouragement—although the proverbial “recovery” seems far off. Challenger, Gray & Christmas reported that 2001 witnessed the largest total number of layoffs in the past eight years. At least we can look elsewhere around the country and notice that we have been harder hit here, in California. In our office markets, all signs confirmed the worst—that leasing activity and net absorption of space were abysmal; rental rates plummeted, and continue to do so; and vacancies—both in the near term and projected throughout the year—are soaring.

The Bay Area closed out 2001, as expected, on an awful note. Absorption of space for the Bay Area was negative 1.34 million square feet. Only San Mateo and Santa Clara Counties showed miniscule positive absorption, offset entirely by San Francisco’s continued poor performance, at negative 1.44 million square feet. Has the pace of new vacancies slowed? NO. Read on.

All the pundits, soothsayers and prognosticators are out on their stumps, all trying to predict “the turnaround”. Since we are all in favor of a healthier economy and try to be eternally optimistic, should we allow ourselves to be clouded by our hopes? In the past 45 days, the markets have seen enormous new vacancies offered for lease:

This is enough space to accommodate 20,000 employees! Bay Area current vacancies have now risen to over 40 million square feet, but it really stands at well over 50 million square feet vacant, if we also consider space now on the market for occupancy later in the year. So are the markets ‘working?’

a) The markets are working, and how. The function of the markets, at this point, continues to be to price in new demand; whether from its existing tenant base (musical chairs for tenants), new start-ups, demand from tenants outside the Bay Area or demand from tenants whose leases don’t expire until late 2002, 2003 or later. Rental rates in San Francisco have plummeted over $10 per square foot per year—just in the last 3 months (this, in addition to the free fall of more than 50% from a year ago). Demand, as we’ve already reported, remains negligible in the City, so we should expect rates to continue to slide, landlord concessions should continue to rise, and broker fees and bonuses to climb. Whatever it takes—the free market will do. The tighter landlords and sublessors try to grip pre-existing rental rates, the freer the fall in rates will be, since demand must be heavily courted in this type of economic downturn.

(b) The economy outside of lease rates and concessions is working, too. Much of the space available is offered on a “plug and play” basis, meaning that the space is completely built out, ready for occupancy, including furniture and Internet and networking cabling in place. Tenants who can take advantage of these opportunities will save enormously versus building anew and purchasing all of the infrastructure.

“Used“ furniture supplies, much of it brand new, are a glut on that market. Telecom equipment; computerware; rdquo retail goods; salaries and benefit packages; cheap interest rates; much reduced security deposits; cheaper housing markets—are all factors far cheaper for employers and new companies than in recent history. These now lesser expensive overhead categories will add fuel, and a silver lining, to a recovery—when it comes.

(c) Slowly, the markets are removing barriers to doing more business…expanding businesses, jump-starting hiring, boosting confidences and, finally, more leasing activity will result from the economic forces currently hard at work.

For all the veterans of this marketplace, the pace of new vacancies has been overwhelming. To help make the point, consider the sheer number of options available to a 10,000 square foot tenant, shopping for space in the Bay Area for occupancy within the next six months:

The abundance of choices in San Francisco has driven rental rates to the point where Bay view space is now leasing—on a direct basis—in the low-mid $30s/sf/year, fully serviced. Sublease space, which in the City comprises more than a third of the total vacancy, continues to drive rates lower at an alarming pace. Again, the markets are working. We should start to see an overall increase in the level of activity, as the market tries—difficult as it may be—to seek equilibrium. Bear in mind that the strongest market in the City is the view space market, and as pricing for the balance of the inventory is adjusted accordingly, it may mean view space priced in the $30s — something quite reminiscent of the markets of the late 80s when vacancies in the City hit 20%. Our experience tells us to never say “never”; it is possible that the top end of our markets could fall into the $20s.

More business failures are coming, without a doubt, but hopefully not of the Enron variety. Rather, we continue to speak of struggling companies, law and other professional firms, all seeking ways to reduce costs, trim personnel and close unproductive offices. There is an indeterminate amount of space forthcoming to the market, in no small numbers, we anticipate. Of interest is that many landlords in the community are competing head to head with their own tenants’ marketing efforts to shed excess space. Oftentimes these owners, publicly traded REITs and other large institutions, refuse to negotiate with struggling tenants for fear of interrupting the cash flows promised to their shareholders.

In 1999 and 2000, when we witnessed record leasing activity in San Francisco, some 5 million square feet of long-term deals were struck with the landlord community. All of these deals, with rental rates streaming from the $50s into the $100s per square foot per year, present troubled situations that will at some point soon return to haunt the market. Few of these businesses, in the current economy, can withstand the overhead for the duration of their 5 to 10 year lease terms. The deals made little sense then; they make less sense now. Landlords will be forced to renegotiate most of these deals, or face a re-letting of those spaces left behind by bankrupt entities.

In any kind of market, it’s impossible, and oftentimes unimportant, to pick the proverbial “bottom”. Most businesses, and the executive teams who manage them, are not so speculative that they would effectively gamble their way through a lease negotiation in an attempt to perfectly time the trade. On the other hand, tenants want to vigorously negotiate the most aggressive terms possible. So, let’s focus on the big picture for a moment. The markets have made a major move in the tenant’s direction. Rental rates and terms have finally landed in a range where many businesses can afford to operate profitably, and that IS significantly new in this market. With continued pressure on rates, tenants who slowly and methodically negotiate in this economy will be the beneficiaries of terms better than we’ve seen in several years—and should be better than was negotiated last week! Moving allowances, beefier tenant improvement allowances, fees to pay for your architect to perform speculative analyses—are readily available throughout the City. If you have a lease coming due in 2002, the market is ripe for the picking.

Dan Mihalovich can be reached at (415) 434-2820, or for more editorial and information about market conditions in the Bay Area, go to www.thespaceplace.net.

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